Well, That Didn't Work

SEC isn't letting the failure of its original short-selling ban stop it from extending it.

The temporary ban on short-selling was supposed to help prop up share prices of troubled financial companies until a fix to the system could be implemented. The SEC has determined that extending the ban for another two weeks will be necessary. However, if the $700 billion "bailout" plan gets passed first, the ban will expire three days later.

After all, it was supposedly the short-sellers who drove Bear Stearns and Lehman Brothers to extinction, and it was the shorts who were riding herd on Fannie Mae(NYSE:FNM) and Freddie Mac until they collapsed, exhausted, into the arms of Uncle Sam. A systemic fix is supposedly needed before we can let the finance industry face the short-sellers again.

So let's see, in the two weeks since the ban went into effect, FirstFed Financial(NYSE:FED) saw its stock fall as much as 60% and Sovereign Bancorp(NYSE:SOV) saw shares plummet almost 80%. Washington Mutual actually failed and Wachovia(NYSE:WB) sold itself to Citigroup(NYSE:C).

Of course, there are the nonfinancial "financial stocks" that have extended coverage, too, like such well-known banking names as diamond purveyor Zale and assisted-living facility Sunrise Senior Living(NYSE:SRZ), as well as carmakers Ford(NYSE:F) and General Motors. Zale got on the list last week, while Sunrise made the cut yesterday, and its stock is down almost 2% as I write.

In reality, the ban has been a failure at propping up stocks, protecting financials, or whatever else the argument was behind instituting it. In short, short-traders haven't been the problem, but rather the whipping boys. It was the risky maneuvers and investments that individual companies undertook that caused investors to bid down their stocks.

Even the SEC admits short-sellers are useful players in the markets. In its statement announcing the extension, the commission noted the important role shorts play "contributing to efficient price discovery, mitigating market bubbles, increasing market liquidity, promoting capital formation, facilitating hedging and other risk management activities, and importantly, limiting upward market manipulation." Despite that, the SEC decided to give the shorts a few more lashes for effect.

Even so, there have been a whole series of unintended consequences from the SEC's actions. Trading has gotten more volatile, with wild swings in prices, particularly at the market's close, and the bid-ask spread has nearly tripled, making it a lot more expensive for you to buy stocks. The convertible-bond market, used by faltering businesses for financing, has also been effectively shut down by the ban. The liquidity that short-sellers bring to the market, along with the efficient price discovery, has been cut off.

What little upside there is comes from the ban remaining in effect for only another two weeks. But that won't really help: The ban is slated to be lifted just as banks are readying their third-quarter financial reports. With expectations that the news will generally be horrible, October may live up to its reputation as one scary month.

Author

Rich has been a Fool since 1998 and writing for the site since 2004. After 20 years of patrolling the mean streets of suburbia, he hung up his badge and gun to take up a pen full time.

Having made the streets safe for Truth, Justice and Krispy Kreme donuts, he now patrols the markets looking for companies he can lock up as long-term holdings in a portfolio. So follow me on Facebook and Twitter for the most important industry news in retail and consumer products and other great stories.